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Ways investors can profit from a market decline

by Wayne Cheveldayoff, 2006-06-22

Buying when it’s cheap, or buying on dips, on the expectation that the market will recover is not the only way to profit from a downturn in the market.

If you think stocks are going down further, you can use short sales and put options to capture the downside as well as reverse participation notes (available at some dealers such as Canaccord) and the more widely available ‘bear’ mutual funds.

The tools are there. In the end, it comes down to whether you are willing to take the bet and the risk that goes with it.

In the United States, ‘bear’ funds, or funds that make you money when stocks are going down, are more common. Rydex and ProFund Advisors offer a variety of such funds.

In Canada, only one fund company, BetaPro Management, has this type of fund. For example, the Horisons BetaPro S&P/TSX 60 Bear Plus Fund gives investors 200 per cent of the inverse of the performance of the large-cap S&P/TSX 60 index.

In other words, if you put the minimum $5,000 required into this fund and the S&P/TSX 60 Index subsequently goes down 10 per cent, you gain (after management fees) approximately 20 per cent.

If you are wrong and the index instead goes up 10 per cent, you lose 20 per cent.

BetaPro has similar leverage-embedded bear funds for the Nasdaq 100 Index and the S&P 500 Index. The same double-whammy inverse gain is offered in other funds linked to a decline in the 10-year Government of Canada bond, Canadian dollar exchange rate, oil and gold.

BetaPro also offers ‘bull’ funds, providing returns of 200 per cent of the underlying index, currency or commodity, so you can bet on the upside as well as the downside.

While most mutual funds apply trading fees if you trade within 90 days of initial purchase, the BetaPro line of funds has no such short-term trading fees.

If you want, you can trade every day, switching in and out of bull and bear funds for stock indexes, oil, gold, and so on, taking advantage, if you are good at predicting them, of all the ups and downs in the markets, without paying trading fees. And you can do it in your RRSP, since these funds are RRSP-eligible.

One drawback is that like other mutual funds, the BetaPro funds are priced once a day at the close of trading. So even if you make up your mind to trade in the morning, you get the end-of-day price, which could be a lot different than what it was in the morning.

Investors wanting immediate and certain pricing can engage in short sales of the many exchange traded funds (ETFs) that mimic the performance of stock indexes. With a short sale, if the index goes down, your capital goes up, since you buy it back at a lower price than what you sold it at. The new gold, silver and oil ETFs traded on U.S. exchanges can also be sold short.

Of course, short-selling has an extra element of risk, since theoretically there is no limit to how much you can lose if the market goes against you (meaning goes up). In contrast, if you buy a stock, you can only lose what you paid. However, this is not a practical problem since short-term traders, whether going long or short, should use stop-loss orders to minimize losses.

Put options, giving the right but not the obligation to sell a stock at a specific price, are ideal for limiting losses when trying to capture the downside.

For example, if you are bearish on oil stocks, you could recently buy put options giving you the right to sell oil-sands producer Suncor (Symbol SU) at $80 a share when it was trading at $81.90 per share. The put options, which would expire in December 2006, would cost $7.50 a share (essentially the time premium for this six-month option).

To profit from this, Suncor’s price would have to drop below $72.50 per share ($80 minus $7.50) by December.

If you are wrong, the only amount you lose is the cost of the put option, since you are not obligated to exercise the put to sell the shares.

Put options on Canadian stocks are traded on the Montreal Exchange (www.m-x.ca), which publishes quotes throughout the trading day.


Wayne Cheveldayoff is a former investment advisor and professional financial planner. He is currently specializing in financial communications and investor relations at Wertheim + Co. in Toronto. His columns are archived at www.smartinvesting.ca and he can be contacted at wcheveldayoff@yahoo.ca.


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©2006 Wayne Cheveldayoff